Value Investors & The Market's P/E Ratio

The P/E Ratio is a tool used by value oriented investors to identify prospective stocks for investment. Value investors usually prefer stocks with low (preferably single digit P/E ratios). The P/E ratio is also used as a tool to analyse the overall level of the market and to decide whether to commit to fresh investments or to bide time and wait for better valuations.

There are many versions of the P/E Ratio in vogue in the investment community. There is the P/E ratio which uses earnings for the most recently ended financial year. Another version uses earnings numbers from the 4 most recent quarters, and is known as the TTM P/E (Trailing Twelve Months). A further variation in the calculation of the P/E Ratio is the Forward P/E, which uses the consensus earnings estimates of analysts. The current price of the stock or index is divided by this forecast earnings level to arrive at the Forward P/E.

The P/E Ratio is a very useful barometer to decide whether to take fresh positions or whether to wait and watch for better valuations. To a value investor, the purchase price and the consequent margin of safety are very important, and hence it is critical to not make purchases when individual stocks or markets are over-valued.

Huge spikes in the market's P/E ratio have often preceded major market crashes. This is evident from the chart shown below. From the Great Depression to the Dotcom Crash to the Great Recession, there has always been a significant spike in the P/E Ratio before the onset of a major stock market crash. The current TTM P/E of the S&P 500 is 21.86. The TTM P/E Ratio of the NSE Nifty is 23.21. Clearly, this is above the long-term average of the S&P 500 as well as the NSE Nifty. Analysts are justifying the elevated P/E ratios by explaining that the TTM earnings underlying the current P/E ratios are depressed by the low corporate earnings in Q3 & Q4 FY 2009, and markets are trending up in the hope that corporate earnings are about to perk up significantly.



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In January 2008, analysts were using the same logic to justify the then high P/E ratio (Nifty P/E > 28) of the market by projecting that forward earnings would continue to grow at heady rates.

For value investors, these high values are cause for caution. Sure, there are many segments of the market, as well as individual stocks, which have still not recovered from their losses during the recession, and are quoting at single-digit P/Es. This calls for a lot of introspection before making investments. What is the reason for the low P/E? Does the company meet the rules of value investing - Competitive Advantage, Management, Margin of Safety, and does it lie within the investor's Circle of Competence? These are important questions to consider